Thursday 27 October 2011

Energy firms' profits are a sign of the impending supply crunch - and the need to build more power plants

The rising price of energy supplies has been much in the news recently, with the high profits of energy supply companies causing a lot of controversy. The regulator, Ofgem, is preparing rules which it intends to stimulate more competition in the market, while energy companies are warning that vital investment in energy infrastructure could be put at risk if the regulation is too heavy handed.

The energy industry is typical example of a sector where competition does not work particularly well.

The business of distributing energy from power plant to end user is a natural monopoly, meaning only one set of infrastructure ever needs to be built. Market mechanisms are of no use here, so the regulator sets the prices that transmission and distribution companies are allowed to charge. This system has encouraged the spending needed to maintain the networks of power lines and substations required to keep the country running. However, it leaves limited incentives for the companies to invest with a time horizon beyond the next five-year price control period.

The business of building power stations and generating electricity is more amenable to the use of market mechanisms. In theory, if generation capacity is constrained, electricity prices tend to rise. In the short term, more generation capacity will come online to increase supply. In the long term, new capacity will be built as companies see the investment in power plants as yielding an attractive return on capital. In reality, the lead time for building new generation capacity is between 3 and 15 years depending on the type of plant you build. Energy companies won’t authorise the investment unless they are sure they will get a good return – so they wait until prices are already elevated before building new capacity. This is what is happening now in the UK electricity market.

Old power plants, in particular nuclear plants, are being shut down and decommissioned. At the same time, demand for electricity is slowly but steadily growing. Prices have risen, allowing energy companies to make higher profits, but new capacity has not yet been installed.

This is the natural course of events you would expect in a system based on market mechanisms, but it leaves an uncomfortable feeling in a lot of people’s stomachs. After all, electricity is pretty much an essential good, so it feels wrong that someone can profit from people’s most basic needs – but that is a fundamental aspect of a market-based economy. The most obvious alternative – nationalised energy companies – is not really a viable answer – so we may just have to get used to energy companies making high profits over the next few years.


  1. Interesting article David, thanks for this. I'm looking into future development of our national grid as part of my research. Apparently we British pay fairly low electricity tariffs compared to the continent (see I read that when we bring a lot of wind power on-grid in the UK, that our electricity cables stretching to the continent may be important in bringing electricity to meet peaks in demand when the wind generation is lower due to weather.
    The caveat is that this electricity will only flow with the correct 'price signals'. Presumably this means electricity tariffs here will have to converge with France, Germany or other countries where cost is greater.

  2. That is a really interesting point, Rob.

    A further problem as I see it is that the promotion of energy efficiency initiatives is primarily the responsibility of the energy companies themselves. This leaves them with a clear conflict of interest, as they earn more the more energy gets used. I think some clever regulation of prices might help get round that but in the mean time lots of energy efficiency technologies are not receiving the attention they deserve from consumers.